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Daniele Bianchi Daniele Bianchi Is Associate Professor of Finance, Queen Mary University of London Ukraine: world financial markets have not broken sweat since the Russian escalation – why? 10 OPINION 17.2.2022 T he economic consequences of armed conflicts have received widespread attention at least as far back as when John Meynard Keynes wrote about them in 1919 in relation to the first world war. Yet as the world braces for a possible war in Ukraine, we still know rel- atively little about the interplay between conflicts and financial markets. One thing we can say is that even dur- ing major armed conflicts, financial markets have often operated relatively smoothly. A clear example is the second world war. Most people would probably think there would have been a sharp dive in the stock market in September 1939 with the invasion of Poland, or after the bombing of Pearl Harbor in December 1941. Yet as you can see from the follow- ing chart of the Dow Jones Industrial Av- erage, that is not what happened. e market instead bottomed much earlier, in 1938, when Hitler annexed Austria as part of his Anschluss plan to reunite all of the German-speaking peo- ple in Europe. is was the first concrete signal of the build-up of a global war. Until the fall of France in the spring of 1942, markets remained extremely complacent about the ongoing armed conflict. In fact, after bottoming again in 1942, the market began a bull run well before the end of the war. is possibly reflected the assumption that the Allies were starting to get their act together. With the full-force intervention of the US towards the end of that year, winning the war was starting to look like a con- crete possibility. e events of the second world war show a key characteristic of financial markets: they react abruptly only to un- expected events, while largely expected outbreaks are priced in (already factored into valuations) well in advance. So, for example, the 9/11 attack triggered a vi- olent reaction on financial markets, but the largely anticipated military occupa- tions of Afghanistan and Iraq were large- ly ignored. is possibly relates to the very nature of financial markets. Investors hate un- certainty more than anything, and there are few situations more uncertain than the threat of a war. When an armed conflict begins, however, to some extent uncertainty resolves and capital is real- located. Ukraine and the markets ese observations can perhaps help to explain the complacency of interna- tional financial markets in response to Russia's announcement that it is recog- nising as independent states the eastern Ukrainian territories of Donestk and Lugansk and sending in "peacekeeping" forces to help defend them from Kiev. e S&P 500, major European stock markets and the VIX (which measures of market volatility) barely moved on a daily basis in response. On the other hand, the Russian stock market index fell by about 10%. is could mean that international capital markets have already been pric- ing in the risks of (a minor) conflict with Russia as part of the slide in stock prices over the past couple of months. e view could be that as serious as this escalation could be, it is unlikely to have a material impact on US, EU or UK economic fun- damentals or corporate profits. If so, giv- en the strategic importance of Russia as a net exporter of natural gas and oil, es- pecially to the EU, this assumption might be questionable at the very least. Meanwhile, the drop in the Russian stock market might reflect a belief that western sanctions will primarily affect the Russian economy. Of course, there is the possibility of contagion effects across countries, especially Russia's neighbours, but these are hard to quan- tify as they depend on the exposure of other countries to the Russian economy. Either way, markets have been condi- tioned not to overreact to largely antic- ipated political and geopolitical shocks. Yet bear in mind that Russian gas pipe- lines feed many parts of Europe. e price of natural gas in Europe has already gone up 11% since Putin's announce- ment, while Brent crude oil is up by 1%. If Russia were to shut off the gas spig- ot, or have its oil infrastructure dam- aged, we could easily see a bigger spike in the price of these resources, which would feed into already high inflation. Interruptions to the ports around the Black and Baltic seas could also exac- erbate continuing disruptions to the global supply chain, which could affect both European and UK recovery from the pandemic in the short-term. In other words, while market compla- cency might have a rationale, it should be taken with the proverbial grain of salt. And all this is under the assump- tion that an eventual escalation in Ukraine should be limited to the Don- bas area. Unfortunately, this remains to be seen. Russian mobile artillery on the move Dow Jones Industrial Average, 1932-43

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